Fifth Circuit values estate tax claim on date of death.

In Estate of Smith, 198 F3d 515 (1999), the Fifth Circuit ruled that claims against an estate must be valued on the date of the decedent's death; post-death events are irrelevant. Also, the Fifth Circuit held that this ruling applies even if a claim is disputed or contingent, with its enforceability uncertain, on the date of death. Estate of Smith will frequently result in increased estate tax deductions for these claims, because subsequent events often result in payments smaller than prior estimates.

Sec. 2053(a)(3) allows a deduction from a gross estate for claims against it that are allowable under state law, but does not specify the valuation date to be used. Regs. Sec. 20.2053-4 supports valuing claims on the date of death. Regs. Sec. 20.2053-1(b)(3) supports waiting until claims are "ascertainable with reasonable certainty" to value them. Also, cases have differed on when claims should be valued. The Ninth Circuit has ruled that claims legally enforceable on the date of death are valued on that date, even if the amount must be estimated. For claims not legally enforceable on the date of death, post-death events are relevant, and the deduction is the amount ultimately paid (Propstra, 680 F2d 1248 (1982)). On the other hand, the Eighth Circuit has ruled that post-death events should always be considered (Estate of Sachs, 856 F2d 1158 (1988)).

In Estate of Smith, Algerine Smith had leased land to Exxon while retaining a royalty interest in oil and gas production. In 1978, the U.S. Department of Energy (DOE) sued Exxon for mis-classifying certain crude oil, resulting in overcharges. In 1983, a court ruled that Exxon owed the DOE $895 million (plus interest), which Exxon paid in 1986. In 1988, Exxon sued Smith and the other royalty owners to recoup part of this judgment.

In 1989, a district court ruled that Exxon had a cause of action against the royalty owners. In November 1990, Smith died. In February 1991, the court ruled that the royalty owners were liable to Exxon. In April 1991, Exxon claimed Smith's estate owed it $2,482,719. In July 1991, the executor deducted that amount on the estate tax return as a claim against the estate. In February 1992, the parties settled for $681,840.

The IRS claimed that only $681,840 was deductible as a claim against the estate, arguing that the claim was disputed on the date of Smith's death. The estate argued that $2,482,719 was deductible, because Exxon's claim was certain and enforceable when Smith died. Adopting the Service's position, the Tax Court ruled that, prior to the district court's 1991 decision, Exxon's claim was unenforceable, because it was uncertain if the royalty owners were liable.

Reversing the Tax Court, the Fifth Circuit ruled that the amount of Exxon's claim (and, therefore, the Sec. 2053(a)(3) deduction) must be based only on the facts that occurred before Smith's death. The Fifth Circuit reasoned that, because the estate tax is imposed on the transfer of property at death, the net value of the property transferred should be determined on the date of death, to the extent possible. The court pointed out that the Sec. 2053(a)(3) deduction may be different than the amount ultimately paid on the claim, just as assets valued in the gross estate are frequently sold for amounts different than their gross estate valuation. The Fifth Circuit ruled that the Tax Court must value Exxon's lawsuit on the date of Smith's death, using the same method used to value a closely held business. It must consider all relevant facts and apply "common sense, informed judgment, and reasonableness." Especially relevant, according to the Fifth Circuit, was the district court's 1989 ruling that Exxon had a cause of action against the royalty owners. The resulting valuation by the Tax Court could, of course, be less than the $2,482,719 claimed by Exxon.

The Fifth Circuit also ruled that date-of-death valuation should be used for all Sec. 2053(a)(3) claims. The court saw no difference between an enforceable claim that might be worth $1 million or zero, and a claim worth $1 million with a 50% chance of being judged unenforceable. Post-death events were irrelevant in both cases. Of course, a frivolous claim would have a date-of-death value of zero, the court added.

On a related issue, the Fifth Circuit ruled that the deduction for the Sec. 2053(a)(3) claim should be reduced by the income tax benefit resulting from the estate's repayment of royalties previously included in income. Under Sec. 1341 (a), the benefit is the income taxes saved in the year of repayment. If, for example, the Sec. 2053(a)(3) deduction, before considering the Sec. 1341 (a) benefit, was $2 million, the Sec. 1341(a) income tax benefit would be $792,000 ($2,000,000 x 39.6%), and the net Sec. 2053(a)(3) deduction would be $1,208,000. This calculation must be made as of the date of death.

Finally, the Fifth Circuit ruled that the allowable Sec. 2053(a)(3) deduction minus the amount actually paid was not discharge of indebtedness income under Sec. 61(a)(12), because no borrowed funds had been excluded from taxable income. The estate did not have a debt to discharge until the parties settled.

Estate of Smith presents a consistent approach to valuing Sec. 2053(a)(3) claims against an estate. Whether other circuits will adopt its broad application of valuing all claims against an estate on the date of death, regardless of their enforceability, is, of course, uncertain. Also uncertain are the standards courts would adopt to value claims not legally enforceable on the date of death. In any event, Estate of Smith provides practitioners with an argument for using the date-of-death value for claims against an estate.

FROM PETER C. BARTON, MBA, CPA, J.D., PROFESSOR OF ACCOUNTING, UNIVERSITY OF WISCONSIN--WHITEWATER, WHITEWATER, WI (NOT ASSOCIATED WITH BDO SEIDMAN)